Alex Western, Managing Director at Think3, talks about the problem he has seen consistently across SaaS startups that have VC funding – overgrowth. Overgrowth normally happens because of misalignment in VC initiatives and founder initiatives. Because VCs want to make 15x on their investments, founders aren’t realizing that overgrowth is actually dangerous for their companies. Alex suggests different approaches on handling overgrowth and how smaller-valued exits might be the best strategy long-term for both founders and VCs.

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Transcript

Alex Western – Managing Director at Think3

I’d like to start with a story. About a year ago I met a company called PowerDrive which sells a CRM solution to the auto mechanic space. The founder Marko is actually become a friend of mine. The company was 3 million a year in recurring revenue US had 90 percent customer retention. It had just raised three million dollars at a 12 million dollar valuation from a venture capital firm and it had just secured a two million dollar secured credit facility from a commercial bank that the venture capital firm had introduced Power Drive to. We just agreed to stay in touch. Power drive, Marco the founder and I. So fast forward six months I reconnected with Marco and he said things weren’t going well. The V.C. firm said it’s time to take it to the next level or kick the growth. So he had expanded into three adjacent markets tire change shops, oil chain shops and paint and body shops. But those customers had different use cases and they had poorer financial profiles which meant that his sales cycles were longer. His conversion rates were lower and customer churn was higher. So at that time he had three point five million in annual recurring revenue. He was posting 80 percent customer retention but he had a million and a half dollars of incremental cash burn from all of the sales and marketing investments. But he had lost his second largest customer who felt neglected because of the focus on growth. All right. Fast forward again to present day and Marco and I connected via video conference about two weeks ago. And he said that the commercial bank which had lent him that 2 million dollars was threatening to foreclose. Because he had been in covenant default for 90 days. He said it was ironic that at the very moment he decided to grow. He was growing broke. Marco’s going to lose his company. That’s just an anecdote but it illustrates a broader point which is there’s a fine line between growing recklessly and growing expeditiously.

And the first thing I’d like to share with you tonight. Is that we Think3 think. That there is an incentives misalignment fundamentally between most VCs and founders and that that incentives misalignment is pushing companies to grow too much too fast and it’s ruining great companies like Power Drive. Fundamentally a founder has the incentive to maximize the value of her company. A VC has the incentive to maximize the value of her portfolio. And those two things aren’t the same thing. To understand why take a look at this illustration for me this is one portfolio company whose future value is represented by a span of potential outcomes at t equals zero it’s worth 1 times invested capital. On the left, in a future states of the world, it could be worth zero. Or it could be worth as much as six times invested capital. Or it could be worth something in between. Same portfolio company to which a V.C. might apply the maximum amount of growth pressure. Growth is another word for introducing volatility. Widening the fan of outcomes for that company. So look at the shaded region. You still can’t lose any more than what you put in. You can’t lose any more than a hundred percent but look at the expanded shaded region up top right.

There is an increased chance that it can return ten eleven twelve times invested capital. So show of hands if you’re a founder. Which would you rather choose. In most cases. Left. Right. OK. If you’re a V.C. which would you rather choose. Left. Right. Exactly. There. There’s a misalignment of incentives because. These are really smart. They understand that their portfolio returns don’t follow a normal distribution. They don’t follow a bell curve they follow a power distribution where literally one or two companies drives the entirety of the returns 20 to 30 percent plod along and return between 1 and 2 x and two thirds actually lose money. So. If you’re a V.C. you have the incentive no matter where you think the company might initially fall on this rank. Force ranking of multiples of invested capital. You have an incentive to try to force every company to be a unicorn to try to shoot for the stars because as a founder you might not make that choice because there’s actually an increased chance of total loss on the right hand side. But as a V.C. you’ll make that choice all day long. Because even if it wrecks every company but one. That’s OK because one is all you need.

OK. Quick show of hands who thinks we’re in a bubble right now. All right. That’s good. So we agree on that and raise your hand if you didn’t just raise your hand because I put you to sleep. Yeah. All right. So I think we should. I’m going to go ahead and skip through these next few slides but I hope. Because there are pretty graphs on them you’ll believe that I did my homework. I want to pause here for a moment. That misalignment of incentives I just highlighted has always existed. The reason it’s a bigger deal now. Is because of the bubble we’re in. The proliferation of venture capital firms over the last five 10 15 years and of fundraising by those venture capital firms has created an environment where only moon shots will do for venture capital firms. It’s created almost a paramedic game of musical chairs where. You need. The companies to outgrow their over capitalization in order to justify their valuation. To pass them on to someone higher up the food chain who’s just going to do the same thing. The misalignment of incentives is worse and is having a greater impact because of how large the industry is and because it’s self reinforcing not self-correcting. Because ironically if and as things start to turn sour VCs actually have to push harder to make up the losses.

Ok. I see someone shrugging over there. So thank you for helping me make my transition. All this has been very theoretical to date. Even if it’s maybe been interesting so. How does this manifest itself what are actually the risks of overgrowth?

At Think3, We keep a database of 60000 B2B technology companies globally. We speak with fifteen hundred of them every quarter. We keep detailed notes on their metrics their progress and their challenges. And from that primary research we’ve come up with. This list of six mutually exclusive collectively exhaustive reasons why we think overgrowth can be bad. I see a handful of people taking pictures of their phone that’s good. You can refer to it later in the interest of time I’m actually not going to walk through each one but I will highlight a few things. In Numbers 1 and 2 when we say debt. We mean. The increase costs tomorrow of shortcuts today. It can be in your product or it can be in your organization. Number three I’d like to share that. We consistently find art ESW Capital and Think3. Founders retrospectively regret making the tradeoff between retention and growth. Even though the simple math is. If you shoot for an extra percent of growth it will make up for an extra percent of churn. Because of those fans of outcomes we looked at because the distribution of returns, most companies aren’t necessarily in situations where they can grow that quickly. So we find they’re usually better off actually focusing on retention not on growth. But they can’t make that tradeoff because they feel a lot of pressure from their venture capital and investors or they feel too much pride to make that tradeoff. But because it’s a regret that’s so often shared with us I thought it was worth highlighting. Numbers 4 and 5 are self-explanatory. But number six I want to take a moment on. Because my college roommate. Is a principal at Bain Capital Ventures. And it’s ironic. That when friends of his. Ask him for fundraising advice. He actually dissuades them from talking to Bain Capital Ventures.

He says that the bar is too high and they don’t wanna play that game. He says that one hundred million dollar exit. Is a bad outcome that something went wrong. And I’m like What. Like I know what you’re talking about but. There is something wrong in that scenario because one hundred million dollar exit a 50 million dollar exit a five million dollar exit can be life changing. It should be a raging success. But. What my college roommate is referring to is each time you raise V.C. funding each time you bring more investors into your cap table each time you have to. Introduce greater and greater growth projections in order to justify that valuation and get to the next step you take more and more options off the table. And pretty soon only a rocket ship to the moon will do and your voices won’t let you take some of the exit opportunities that might otherwise look pretty attractive because they’ve got too much skin in the game.

And again think back to the distribution of returns they need to go for 15 x not one two three or four X that doesn’t drive their fund returns. And there’s nothing pernicious about this approach by VCs. I’m not I’m not even critiquing it. I’m just trying to share that that’s how the model works. So we should be aware of it. Those of us who are founders and running our companies. All right. So those are the six risks to overgrowth as we see them. So to take stock real quick. We’ve tried to talk about the fact that we at thing three believe there is a misalignment of incentives between venture capitalists and their portfolio companies. That leads to over focusing on growth. And we’ve talked about the fact that the bubble is actually exacerbating that impact.

And now we’ve talked about why we think it’s dangerous. So what do you do with all that good news right. I’m just a barrel of laughs today. Should I point this somewhere. Would you mind taking me to the next slide if you could. Notwithstanding I’m going to walk through a framework. That will help us. Think about. What we should do because a talk is not very helpful that just identifies a problem and then tries to explain it. What should you do about it. So this is the takeaway. So if you’re asleep wake up. There are basically three states of the world we think 3C for entrepreneurs. You should do some soul searching. And it’s no one ever has the time to but ask yourself whether you really want to have a lifestyle business or whether you want to play in the big leagues so to speak. And there’s nothing pejorative about a lifestyle business. We just mean a business where you can have a life. We mean a business where. A 10 million dollar exit would be good. Where you can keep more equity where you wouldn’t be forced to grow as quickly most of the founders we talked to actually want to choose the lifestyle option but, they’re almost sort of embarrassed by it given the market we’re in. So they feel like they have to sprinkle a little bit of big leagues into it and that just makes their lives more complicated.

So some actionable advice is don’t necessarily go for the Tier 1 bases or the big names especially if you think you might be in Camp 3 because the prestige really does come with strings. But you’re all at SaaStr conference which probably means you’re not necessarily building a lifestyle business. So let’s talk about if you choose. No I want to play the game at. The highest possible level. I want to play in the big leagues. Then to oversimplify. There’s one of two possible outcomes Either it’s the first state of the world. And it works. Like it clicks product market fit. Everything even if only briefly. And if you actually find that perfect scenario just put the gas pedal to the floor and dance until the music stops. Rays from the Tier 1 v C’s just hang on. It’s gonna be painful but hang on. The reason I put zero point zero two percent on that line in the decision tree though is there was some now famous research done by cowboy ventures into outstanding. V.C. backed startups. And they found that zero point zero two percent of U.S. backed startups become unicorns. And our own research suggests that only about 10 percent are ever on escape velocity trajectory or above the Mendoza line so to speak. Even if only for a brief time. And that implies that most founders should actually probably be choosing the lifestyle option.

But where’s the fun in that?

So what should you do if you’re in the second State of the world because that’s the likelier outcome right. You don’t want a lifestyle business you want to play in the big leagues but. It is so rare that that actually pans out. Our unusual advice and hear me out. Is sell more quickly give up. What we mean by that is founders should more often be selling their companies more quickly and moving on to start more companies because they get a lot better every time they do it. Interesting from the same cowboy ventures research that 90 percent of unicorn teams had worked together previously and the average age of a founder was 34. It means it takes multiple shots to get it right. It’s not someone in their college dorm room it’s not someone at the beginning of their career.

We also found not we cowboy venture is also found and I’m plagiarizing their stuff that once they were in the unicorn venture 90 percent of those startups never pivoted and 100 percent of those startups were always above the Mendoza line. The Escape Velocity trajectory and the hard lesson from that piece of the research is. The second. You think you’re not headed to the first state of the world. You need to get out. Because statistically speaking there’s not going to be a third pivot or a second bridge financing or you know a growth inflection that’s just around the corner. Statistically speaking it doesn’t happen. There’s only one slack. What that means.

Again. And this is the real take away from the talk. We at Think3 think. That most founders tragically underestimate the value of their time as being their portfolio. Just like venture capitalists can think of their capital as their portfolio. They get many portfolio companies. But most founders think that well this is my one shot. This is my baby. And our advice is that it’s actually important to try to force yourself to be more rational than that to give up more quickly the second you think you’re not on escape velocity trajectory. Because you can try again and you’ll get a lot better every time you do. And that’s why we founded Think3. Because we have an operating model and a permanent capital solution for those who want to do right by their customers or their investors or their employees and whose companies deserve sustainability and to be made profitable and to have a legacy. But it’s just not possible to build methodically. A pretty steady Eddie company with venture financing. In today’s environment because everyone is shooting for the moon. And there’s no points for second place.

Okay I’ve been talking for like 15 minutes. So it’s time to wrap this up. There are three takeaways. Number one. We think most founders don’t understand that there is a misalignment of incentives. Implicitly between them and their venture capitalists and that that misalignment results in an over focus on growth. Number two. We think that most founders don’t realize that the over focus on growth is actually dangerous for their companies. And number three. We think that most founders can actually use the over focus on growth to their advantage like a judo artist either by more often choosing the lifestyle option or by having a more sober approach to their relationship with their companies and with VCs by actually selling companies more often more quickly to take their learnings and try again and again. And ultimately even though they’re selling individual companies for lower valuations, they amass greater wealth for themselves and create more value for society as a whole. If they follow that path. And. That’s really the crux of why we think growth is sometimes bad for startups but what we think the opportunity is from it. Because Marco of Power Drive learned this lesson the hard way.

When he and I were talking two weeks ago and he was sharing that he thought that the bank was gonna foreclose. He sort of said like what do I do. And I share with him a story of he’s a car guy and I’m a car guy of a mid 20th century Italian engineer named Enzo. Who in 1957 Milla Muglia race debut the fastest biggest car he’d ever built because he was in growth mode and it was called the three thirty five s it was a monster V12 it went 200 hundred miles an hour three hundred kilometres an hour in 1957 it’s a beast. During the race. It busted a tire. It careened off the road into a roadside crowd. It killed both drivers and nine spectators. Anyway he was like. Thanks Alex. So like your takeaway is okay too little growth you die. Just the right amount of growth. You thrive in too much growth you die.

I told him sort of. I told him my point was the engineer’s name was Enzo Ferrari. I told him my point was. He should have sold his company a year ago. But if he still had the ambition he should give up now and go start another one. I told him my point was that growth like speed is inherently dangerous. But, he should keep racing he should keep building. Just like Enzo Ferrari. That is the unusual but I think necessary message that we wanted to share with you this afternoon. Thank you for listening.

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Co-Founder and CEO of EchoSign from inception through tens of millions in cash-flow positive SaaS revenue and acquisition by Adobe Systems Inc.
Jason then served as Vice President, Web Services at Adobe, where EchoSign was named the most successful acquisition of 2011-12, posting 199% YoY growth.